Being able to assess risk allows you to make sure you are not caught unguarded when investing in financial products

I won't need to go to great lengths to make you understand that it can happen, just think of the Lehman Brothers Minibonds and you will understand what I mean. Assessing risk is not that difficult, but you need to get used to it. By the end of this article, you will know how personal investments work, what risk is, how does it look like and how to make sure you understand it properly.

So here is a first question, how much is $1,000 invested at 8% after 5 years? If you can answer this without a calculator, you do not need to read any further. If you are like me however, I need to use Excel to come up with the answer. I can write it down in mathematical terms (given hereunder), but giving the outcome of it without using a calculator is almost impossible.

The reason why it is not easy is because our mind is trained to calculate linear equations. For example, if I invest $1,000 at 8% return, after one year I make $80. This is easy to compute because it is linear. As another example, if I need four hours to reach the neighbouring city by driving at 100 km/h, how much time do I need if I drive at 200 km/h? Easy ...

That much for linear processes; mathematics get tricky when non-linear equations come into play. And that is exactly what happens with the compounding effect of long term investments. 8% return over two years is not just 2 times the return of one year. It is actually an exponential process, hence non-linear.

As a result, Excel is your friend to solve this kind of equations. Excel will give you a quick answer and it will show you how your investments grow year-by-year to tell you how much you make after 5 years. Excel is a great tool, it is easy to use, and you can plot the results. Everybody is familiar with Excel and it is an industry standard.

Unfortunately, if you now want to know how much you will have at retirement while investing at 8% and you buy a property 3 years down the line with some rental income and a loan to be paid back, things get very complex with Excel. It is of course possible, no doubt about that, but now just imagine that you want to do some scenario analysis on whether to buy your property 6 years from now instead of 3 years from now, or you want to optimize your retirement, or some other scenarios, I wish you good luck with Excel. This is going to take you quite some time, and for each scenario you have quite some work to do. Finally, you are never sure you did not make any error, quite a pain actually.

Fortunately, there is a solution. The Wealth Manager will do the calculations for you in a blink of the eye, and scenario analysis has never been made so easy. The first step is therefore to get accustomed to the Wealth Manager to understand the simple basic principles of personal finance. After that, I will introduce the risk factor. It is important to get familiar with simple retirement planning first before moving to the more advanced long term risk calculations; one step at a time to discover the true value of risk assessment.

When using the Wealth Manager, you are able to look at how investments behave in the long run. In a normal situation, you first experience a wealth accumulation period before retirement, and during retirement you experience a draw-down phase. Your savings will decrease since you use your savings to pay for your lifestyle expenses.

However, looking at a steady return of let’s say 8% per annum is quite rosy to what we know from the stock market. Bull runs yield much better returns than 8% and bear markets actually destroy much value. The latest credit crisis is a good example of value destruction that happened at an astonishing pace.

This is all about risk. Risk is defined as a measure for the difference between the expected return and the actual return. During bear markets, the return on your portfolio will be much lower than in normal years, or during bull runs for that matter. And obviously, a market crash will yield losses compared to positive returns.

The question is therefore how to do scenario analysis on potential stock market crashes? We know downturns happen every now and then, with more or less intensity. The last two downturns in 2002 and 2008 were quite impressive, who says we won’t have any big crash in the future? And by the way, what is the impact of such downturns on my long term portfolio?

The Wealth Manager provides a very special icon entitled ‘Market Crash’. You can drag and drop this icon as many times as you want to simulate more than one market crash in the future. The ‘Portfolio Drop’ parameter enables you to decide by how much your portfolio value will drop in a specific year in the future.

This feature gives you the possibility to get more familiar with risk, what it means and what the impact is on your portfolio. A more detailed description on how to use this icon together with screenshots can be found in the article entitled 'How horribly does a market crash affect my retirement?'

Although the market crash icon provides the user with a good sense on what risk means, it is solely based on the user’s input and on the user’s perception of how the future will look like in terms of potential market crashes.

The good news is that risk can be calculated in a more scientific approach. If by now you are ready to simulate risk boundaries, you can use our Risk Manager to visualize how risk behaves in the long run. You can also find more info about it in the article entitled ‘Introducing the Risk manager’, it gives the background on how risk is defined and how it translates into long term risk as well as how to use the Risk Manager.

But let’s stick to the point, what is risk and which products provide me a risk-free investment vehicle?  The definition of an investment with zero risk is given by the US Treasury Bills, or the US Government Bonds. This is a relative definition, but it is a good proxy to start with, why? Because the US never defaulted on its bonds, and that is the industry standard. However, there is a problem with it, since this is only true for investors whose base currency is the USD. For investors with different currencies, it gets tricky, so we’ll stick to the US Treasury Bills for now.

Other Government bonds pay a premium compared to the T-Bills (acronym for the US Treasury Bills), because there is a risk related to it. The larger the premium, the larger the risk. In finance, the premium is set by the risk compared to the T-Bills, and how do we know what the risk is? Well, that is where rating agencies play their role, and the market consisting of millions of investors and market makers (banks and hedge funds) trade the bonds such that the instant price defines the premium. If a country suddenly becomes more risky (think of Russia for the moment), the price of the Russian Government bonds will fall, hence the yield (or implicit premium) will rise.

The return or yield is therefore strongly linked to the inherent risk! A BBB rated bond is cheaper (or has a larger premium) compared to a AAA bond, this reference is given by the rating agencies. It is important to notice that there is a trade-off between return and risk, the larger the return, the larger the risk. There is no free lunch.

This principle can be extended to stocks as well, the larger the return you expect from a specific stock, the larger the risk the market thinks is involved with that stock.

Stocks are usually more risky than bonds, and between bonds and stocks we have real estate investments. It is usually less risky than stocks, but more risky than bonds.

The different returns and risk can be put in a graph as shown below. It is very useful to understand that graph and to always keep that graph in mind when thinking of investing in a specific product. If somebody offers you the opportunity to invest in a fantastic product with an enormous return, be careful and just think of the following graph, it means that the risk involved is also enormous!

This graph is the basis of finance, and we can derive many things out of it: we can map specific financial products compared to benchmarks, we can map a portfolio, and we can also do much more interesting things such as visualizing leverage and optimizing a portfolio.

As an investor, you know that stocks are more risky than bonds, but did anybody ever quantify the difference in risk between stocks and bonds? Did you ever see risk numbers telling you something that you understand?

Of course you hear Jim Cramer on CNBC talking about the huge surge in volatility, and you might have heard of 15% volatility, but what does it all mean to us? We, retail investors, we understand 8% return, but what does 15% or even 5% volatility mean?

This is where the Risk Manager comes into the picture! Using this great tool, you can now visualize the volatility. Isn’t that great, at last a tool that gives you an intuitive graph on what risk and volatility mean, and it is based on the stock market statistics.

As an example, if you use the Risk Manager with 3% return, the volatility is equal to 0. Why is that? Because it assumes that at 3% return per annum, you are investing in either T-Bills or fixed deposit or just a savings account. I agree with you that today the returns are lower than that, but over the long run, i.e. more than 10 years, the historical returns of zero risk are around 3%. We can argue with that, but that is not the point of the discussion. The point is that we set a reference as being zero risk, and you see in the graph that there is no downside as can be seen in the screenshot below.

Now that we know our reference, what is the risk involved when investing in the stock market? Taking the S&P500 as a proxy for the stock market, over the last 50 years, the average annual return has been 8% and the annual volatility (or standard deviation) is …. 15%!

The standard deviation, a.k.a risk a.k.a volatility is twice as much as the return, but what does it mean? Using the Risk Manager and keying in 8% return over a period of 30 years, we get to see the risk: the potential downside is to have less than half what we expected!

The downside boundary shown using the red area tells you that you still have a 16% probability of ending up with less than that. With 84% chance you should end up with more than this lower boundary, but you never know, it could be less than that!

This is what risk is, this is what 15% volatility means, and this is how you can visualize it, how to feel it, and how to make sure you understand it. Because investing is risky, you should make sure you fully understand how it works. And by the way, investing in very risky assets does not behave the same. Even if the returns are very high, a high volatility will give you a totally different behavior than the one shown in the graph.

Using the Risk Manager you can visualize and understand how risk works when investing in a portfolio of products. The tool will show you what your optimal return should be in order to minimize your downside risk such as not to be bankrupt before the end of your life.

A scenario analysis will quickly show you that a safer portfolio might not turn out to be safe enough based on your contribution rate, a little more aggressive portfolio might get you out of trouble. However, beware, the more aggressive your portfolio, the more risk you take. And just maximum risk is not the solution, because then you risk of losing everything. I will expand more on how tricky a risky portfolio can be, but that will be in a following post. For now, the point is to understand that returns come with risk.

The way return is related to risk is depicted in the figure below. This is a graph commonly used in finance, where return is function of risk, and the curve shown in the figure represents the efficient frontier. Basically, it says that you cannot end up above this curve with a portfolio of financial products (unless you use leverage).

The blue dot on the left marks the zero risk investment bonds, or T-Bills from the US Treasury.

The efficient frontier is a very important achievement in finance, because it will tell you what portfolio of products you should invest in depending on your risk profile. As such, understanding your personal risk profile is the most important aspect of building your portfolio, because everything else will be defined by it. The returns are a function of the risk you are comfortable with, and the portfolio is then extracted out of the market data. Any change from that optimal portfolio is fine tuning based on your views, opinion and expectation on how the market might evolve.

Personal finance is therefore a trade-off between risk and return, the lower the risk you are comfortable with, the lower the expected return.